Download Permanent and temporary factors in broad money growth

ECONOMIC
AND MONETARY
DEVELOPMENTS
Monetary and
financial
developments
Box 2
PERMANENT AND TEMPORARY FACTORS IN BROAD MONEY GROWTH
Notwithstanding the impact of some temporary
special factors around the turn of the year, the
annual growth rate of M3 has seen a gradual
strengthening since mid-2010 (see Chart A).
In qualitative terms, the simultaneous
strengthening of MFI loans to the private sector
suggests that this development may represent
a pick-up in the pace of underlying monetary
expansion. This view is supported by a variety
of quantitative approaches to estimating
underlying monetary trends which suggest that
monetary dynamics have recently bottomed
out and are now showing tentative signs of
recovery.1 Against this background, this box
provides a further quantification of the persistent
component of M3 growth using techniques that
estimate the contributions of temporary factors
within an empirically consistent framework,
namely a large Bayesian vector autoregression
(BVAR) model developed for the purpose of
monetary analysis.2
Assessing the pace of underlying money
expansion
Chart A Growth in M3 and underlying M3
(annual percentage changes)
range of measures for “underlying” money growth
M3
MFI loans to the private sector
14
14
12
12
10
10
8
8
6
6
4
4
2
2
0
0
-2
-2
-4
-4
2005
2006
2007
2008
2009
2010
Sources: ECB and ECB calculations.
Notes: The range of measures for underlying money growth are
derived using some of the methods described in the box entitled
“Underlying monetary dynamics: concept and quantitative
illustration” in the May 2008 issue of the Monthly Bulletin.
Gauging the pace of underlying monetary expansion is an important aspect of monetary analysis,
as it provides an insight into risks to price stability over the medium term stemming from
monetary developments.
In attempting to identify this underlying monetary trend, the natural starting point is to decompose
actual money growth into two broad components: persistent and temporary. The former may
be associated with the growth of bank credit, since the implied general expansion of bank,
household and firm balance sheets is likely to have a lasting impact on money holdings. The
latter may be associated with “portfolio shifts”, which reflect substitution between money and
non-monetary assets driven by yield or risk considerations that are typically of a more transient
nature. Special factors of an institutional nature may also exert a temporary effect on money
growth. On the basis of this decomposition, observed monetary growth can be corrected for the
impact of temporary effects and distortions so as to estimate the underlying monetary trend that
1 The methods used to estimate these various measures of underlying monetary growth are described in the box “Underlying monetary
dynamics: concept and quantitative illustration” in the May 2008 issue of the Monthly Bulletin. These empirical measures are, of
course, imperfect proxies for the latent concept of “underlying” monetary expansion. In addition, it must be borne in mind that the
signalling quality of the various empirical measures may vary over time.
2 This model is presented in Annex 1 to Chapter 4 of Papademos, L.D. and Stark, J. (eds.), Enhancing Monetary Analysis, ECB,
Frankfurt am Main, 2010. For more details see Giannone, D., Lenza, M. and Reichlin, L. (2009), “Money, credit, monetary policy and
the business cycle in the euro area”, mimeo, ECB.
ECB
Monthly Bulletin
March 2011
25
is associated with the emergence of risks to
price stability over the medium term.
Chart B Actual and cyclically-adjusted
M3 growth
(annual percentage changes; percentage points)
A model-based analysis of temporary
factors shaping monetary developments
To supplement and enhance the assessment
made on the basis of existing measures of
underlying monetary growth, this box presents
a new model-based approach to designing
measures of annual M3 growth corrected
for the impact of the business cycle or other
temporary factors. The tool applied is a large
BVAR model.
contribution of business cycle shock to M3 growth
actual M3 growth minus contribution from business
cycle shock
actual M3 growth
14
14
12
12
10
10
8
8
6
6
4
4
2
2
Fluctuations in money holdings may result
0
0
from changes in the pace of real economic
-2
-2
activity and income (proxied in this model
-4
-4
by industrial production). Chart B shows the
2000
2002
2004
2006
2008
2010
resulting estimate of the contribution of the
Sources: ECB and ECB estimates.
Note: Contribution of business cycle shock estimated via the
business cycle to M3 growth and compares the
BVAR model as explained in the main text of the box and in
footnote 3.
annual growth rate of the headline M3 series
with that of the M3 series excluding such a
contribution.3 The chart suggests that annual M3 growth is typically not very strongly affected
by the business cycle: although the magnitudes of actual and corrected annual M3 growth differ
by up to 2 percentage points in specific months, overall the two time series profiles do not exhibit
significant qualitative differences. With regard to the recent period, it appears that the recovery
in actual M3 growth was at first held back and for a short time increasingly dampened by the
business cycle, although this effect has diminished over more recent months.
There are, of course, other temporary shocks beyond those associated with the business cycle,
such as those related to speculative activity. Using the BVAR model as described above, it is
possible to estimate the impact of transitory shocks on M3 growth.4 Chart C, which illustrates
the contribution of these transitory shocks to annual M3 growth, shows that their impact goes
beyond that of the pure business cycle shock and, for instance, also identifies a large part of the
portfolio-shift period between mid-2001 and 2003 as being due to such temporary shocks.5 This
period reflects the exceptional preference for liquidity, which, in the context of this model, is not
specifically addressed and thus only imperfectly identified. The model does correctly identify the
onset of the period in mid-2004 when the increase in M3 growth reflected a strong co-movement
of money and credit and thus indicated the more persistent, or “underlying”, nature of the
3 The shock is that which accounts for the maximum variance of euro area industrial production at medium to high business cycle
frequencies (cycles shorter than eight years). Note that this “business cycle shock” is a non-structural shock, as it is not based on any
identification restriction, and it can be seen as a linear combination of shocks driving the real business cycle.
4 The method consists of finding from among the possible shocks to euro area M3 those which account for the maximum variance at
medium to high frequencies, labelling them as “transitory shocks”, and then computing their contribution to M3 growth. The measure
of “permanent” M3 growth can then be derived by subtracting this contribution to M3 growth from actual M3 growth. In this case the
shock is also non-structural and therefore cannot be interpreted in economic terms (unlike, for example, a temporary money demand
shock), but it can be seen as reflecting a combination of temporary shocks directly affecting M3 which may also include – at least partly –
the business cycle shock discussed above.
5 See the article entitled “Money demand and uncertainty” in the October 2005 issue of the Monthly Bulletin.
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ECB
Monthly Bulletin
March 2011
ECONOMIC
AND MONETARY
DEVELOPMENTS
Monetary and
financial
developments
Chart C M3 and its “permanent” component
Chart D Impact of temporary shock
by monetary instrument
(annual percentage changes; percentage points)
(percentage points of annual M3 growth; percentages per annum)
temporary M3-M2 shocks
temporary M2-M1 shocks
temporary M1 shocks
slope of the yield curve
contribution of temporary money shocks
actual M3 growth minus contribution from temporary
money shocks
actual M3 growth
14
14
4
4
12
12
3
3
10
10
2
2
8
8
1
1
6
6
0
0
4
4
-1
-1
2
2
0
0
-2
-2
-2
-2
-3
-3
-4
-4
-4
2000
2002
2004
2006
2008
2010
Sources: ECB and ECB estimates.
Note: Contribution of temporary money shocks estimated via the
BVAR model as explained in the main text of the box and in
footnote 4.
-4
2000
2002
2004
2006
2008
2010
Sources: ECB and ECB estimates.
Notes: Contributions of temporary money shocks estimated via
the BVAR model as explained in the main text of the box and
in footnote 4 to the components of M3 separately. The slope of
the yield curve is defined as the difference between the euro area
10-year government benchmark bond yield and the 3-month
EURIBOR rate.
monetary expansion. With regard to the current situation, most of the recent increase in annual
M3 growth seems to be explained by the declining negative impact of such temporary shocks.
It is worth noting that the contributions from the business cycle shock and the transitory money
shock do not coincide and appear to be interrelated only in certain specific periods (such as
from 2007 onwards). Indeed, the overall correlation between these two contributions from 2000
to 2010 is only about 42%. This suggests that there are many transitory shocks to monetary
dynamics beyond those coming from the business cycle.
Looking at the impact of temporary shocks on M1, M2-M1 and M3-M2, it is possible to obtain some
insight into the nature of such shocks (see Chart D). For example, the contributions of temporary
M1 shocks to M3 growth are highly correlated to the analogous contributions of the business cycle
shock. The same does not apply to the other components of M3. A high positive correlation is also
found between the contribution of temporary M1 shocks to M3 growth and the slope of the yield
curve, while a significantly negative correlation relative to the latter is found for the contributions
of temporary shocks to the other components of M3. The latter relationship can be expected, given
that a steep yield curve provides investors with an incentive to shift their funds to longer-term and
arguably riskier assets outside of M3. This negative relationship can be seen in Chart D in the
period since 2004, whereas in the period of exceptional portfolio shifts between 2001 and 2003 this
negative link seems to have been overcompensated by uncertainty-related shifts into M3-M1. On
balance, it appears that temporary M1 shocks are largely associated with the drivers of the business
cycle, while temporary shocks to M3-M2 and M2-M1 are more related to the yield curve.6
6 For an analysis of the impact of the yield curve on monetary dynamics, see the box entitled “The impact of the yield curve on recent
developments in monetary aggregates” in the December 2010 issue of the Monthly Bulletin.
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Monthly Bulletin
March 2011
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Conclusion
Overall, the model-based derivation of the impact of temporary shocks on the growth of monetary
aggregates supports the indications from available measures of underlying monetary expansion
that the recent strengthening in annual M3 growth does not translate one-to-one into an increase
in underlying money growth. This is because the strengthening reflects a gradual fading of the
dampening impact on money growth of transitory factors, such as from the slope of the yield
curve and the cyclical position of the economy. Moreover, when corrected for the impact of the
business cycle and other transitory shocks, the outcomes for M3 growth currently fall within the
range indicated by available measures of underlying monetary growth. The pace of underlying
money growth has remained higher than that of annual M3 growth, but continues to be moderate,
suggesting that risks to price stability over the medium-term remain contained.
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ECB
Monthly Bulletin
March 2011